Camille Van Vyve
13 Feb 2024
Why our brain is not made for long-term investment
Interview with Laurent Hermoye, CEO of Imagilys, a Belgian company specializing in brain imaging.
If Imagilys is obviously aimed at the medical profession as a diagnostic tool, you are passionate about the brain and cognitive mechanisms in general. Are you particularly interested in finance?
I am first and foremost an engineer by training, and I will always remember that first course in political economy where you were hammered home with the basic hypothesis, the foundation of this whole discipline: “Economic agents are rational”. However, agents are NOT rational! This observation led to the work of behavioral finance, which studies the influence of psychology on market finance. This area really interests me.
The starting point for your reflection is the book "Thinking, Fast and Slow", by Daniel Kahneman, Nobel Prize in Economics in 2002.
In this book, Kahneman explains that the brain is made up of two systems: “system 1” and “system 2”. Note that he uses this very neutral terminology no doubt on purpose – without opposing emotion and reason or the limbic and frontal system. Thus, "system 1" is the fast and intuitive system. It is at work in our daily decisions, for example when it comes to buying a jar of Nutella at the supermarket. “System 2” is slow and rational. It is the reference system for decisions that we consider more important, such as a career change.
These two systems coexist for good reasons, right?
Yes, nature is well made. Imagine if each of our decisions had to be made using system 2, systematically weighing the pros and cons… It would be perfectly unbearable! The problem is that, in some cases, system 1 takes over system 2, and our brains take shortcuts.
What kind of shortcuts?
They are called cognitive biases and there are many of them. For example, availability bias depends on how quickly an example comes to mind to assess a probability. If I had told you in June 2020 that my 75-year-old uncle had died coughing, you would no doubt have directly thought of the Covid... It's obviously a shortcut!
And some of these biases apply particularly to financial decisions…
Absolutely. Take for example the disposition effect. In your portfolio, you have a stock in a troubled company that has fallen in value from 10 to 2 in a few months. Your intuitive reaction will probably be to hold it in the hope that it will go up. However, rationally, you would rather sell it and buy another stock for which the outlook is more favorable, so as to increase the value of your entire portfolio.
Is it one of these biases that makes it difficult to understand the long term?
This is indeed, among other things, the hyperbolic discounting bias – by which we tend to value the immediate reward more than the future reward. This bias is reinforced by a biological phenomenon because the reward is accompanied in the brain by the secretion of dopamine, a neurotransmitter which is hyper addictive. Dopamine is notably released by sex, consumption of sugars, drugs… which can in turn become addictions.
So our brain is “wired” for immediate reward?
Yes, it is undeniable. One experience in particular demonstrates this, and I like to cite it as an example. An adult presents a child with a marshmallow on a plate and says: “I'm leaving for 5 minutes. If you haven't eaten it when I come back, you'll get a second one. In the vast majority of cases, the child eats the marshmallow in front of him.
And... is it serious?
We all have this tendency, it's not a disease! That said, it has also been proven that those who manage to resist and postpone the reward have a form of mental toughness that is an asset in their adult life.
I have another experience in mind, financial this time. You play heads or tails: if it's tails, you win a million euros. But you have the right to replace the bet with an immediate win of two hundred thousand euros. What do you choose?
The bet… I am an entrepreneur, I like risk!
Fortunately, long-term investing in a basket of global equities isn't so black or white. It's more about postponing the reward than risking losing everything...
This is true, even if the risk still exists in the stock market. But again, I believe it is in our interest to force ourselves to consider the long term, especially when it comes to savings. At least if you want to make the most of your old age!